12/28/2009 @ 6:00AM

Get Briefed: 2010 Outlook

Christopher Hyzy is managing director and chief investment officer at U.S. Trust, Bank of America Private Wealth Management. He oversees portfolio management and investment strategy for private wealth management clients. Hyzy was previously an investment strategist for U.S. Trust.

Paul Maidment is editor of Forbes.com, overseeing all editorial content, and executive editor of Forbes magazine. He is an awarding-winning financial journalist who hosts a weekly video commentary, Notes On The News, where he brings his deep understanding of global affairs to an informed audience.

Bernie McSherry is senior vice president of strategic initiatives at Cuttone & Co. He has served in a number of leadership positions within the industry and has chaired several New York Stock Exchange committees and served as the NYSE governor for six terms. He is a past president of the Alliance of Floor Brokers, an industry trade group.

Carol Pepper is chief executive of Pepper International, which currently manages more than $500 million in assets for high-net-worth families. The company provides virtual family office services to wealthy families in both the U.S. and Europe.

Venezuela’s president chastizes bankers and closes seven small banks, but won’t nationalize the industry.

“Bankers should be shown for what they really are to the public: vulgar robbers, thieves in ties, pickpockets and obstinate kleptomaniacs.” So said Venezuela’s President Hugo Chavez in his newspaper column Sunday. The ever tub-thumping president is putting his money where his bombast is by closing seven small banks for various alleged infractions and purging senior bankers.

Today, a long-standing ally of the president, Science and Technology Minister Jesse Chacon, was caught up in the affair, resigning his office following the arrest of his brother Saturday and the shutting down of the bank he headed.

The widening scandal has triggered a purge of bankers and businessmen with ties to the government, one that the populist leftist Chavez is likely to use to bolster his waning popular support going into what will be an important legislative elections year. Eight bankers have been taken into custody, including Giuzel Mileira, the director of the Banco Real.

While Chavez has threatened to nationalize the entire private banking system, he is unlikely to do so. Even the closure of seven small banks since mid-November has caused turmoil over the past weeks, and he is unlikely to risk destabilizing the economy by taking on the country’s big private banks, which are for the most part well capitalized and profitable, despite heavy exposure to government debt.

State-controlled banks now account for only some 20% of the industry by deposits. Those from two of the banks taken under government control, Confederado and Bolivar Bank, and two of those closed, Banpro and Canarias, have been transfered to the state-owned Bank of Venezuela, the country’s third largest bank and which the government bought from Spain’s Santander in May.

The president has repeatedly chastised private banks for insufficient lending for development and has promised to create a “new socialist financial system,” in line with increasing state control of other parts of the economy, notably energy, in recent years.

Chavez needs more bank lending to stimulate recovery with the economy having fallen into recession in the third quarter with a year-on-year contraction of 4.5%. And he needs a growing economy to underwrite his socialist agenda. Foreign investment, except Chinese and Russian, is increasingly wary of the country. More bank takeovers would make it warier still.

More arrests are possible. More than two dozen warrants and orders not to leave the country are out including nine requests to Interpol for international arrests. At least one banker is reported to have fled to Miami. But however much he publicly disparages them, Chavez will need Venezuela’s private bankers.

***

Intelligent Investing Panel

SEC: Change You Can Believe In?

Alexandra Zendrian, 08.24.09, 04:00 PM EDT

The Commission has been stepping up its enforcements, but is it too little, too late?

Don’t look now, but the Securities and Exchange Commission is back. Or so it’s latest raft of regulatory actions and enforcements would have you believe. But how much can the general public trust the SEC to start cracking heads once again? Our industry observers are not quite sure.

Still, there are at least some reasons to believe the Commission means business. Since Mary Schapiro has been named chairman changes have been made to both the structure of the SEC and the markets that the regulator covers. The Commission is working on regulation for short-selling, looking into dark pools and flash trading and changing some of its staff members all at the same time. It’s also started to enforce tougher regulatory standards.

To wit, in just the past month, the SEC has charged
Terex Corporation
and
General Electric
with accounting fraud, as well as charging Bank of America with misleading investors about billions of dollars in bonuses that were given to Merrill Lynch & Co. executives before the BofA acquisition, among other things.

It also made former
American International Group
CEO Maurice “Hank” Greenberg pay $15 million, saying he helped create the false impression AIG was meeting or exceeding earnings and growth targets. Greenberg neither admitted nor denied any wrongdoing.

In other words, the SEC is trying to make the case that it’s the cop on the beat once more. Is it? It will take more time to know for sure. But ultimately this step up in enforcement might not be enough to restore investor confidence and impact the markets that have been rocked by a recession and trading scandals, our industry observers say.

One problem is that the SEC has long garnered criticism for not having the right kind of people in its organization and not being effective enough. “Traditionally they’ve hired mostly lawyers who have no experience in trading or anything that would help them even discover that (Bernie) Madoff was a crook,” says Margaret Starner, Raymond James senior vice president. To combat this lack of experience and trading knowledge, the Commission could look into outsourcing some of its work to other agencies, she adds.

Matt Samelson, Woodbine Associates principal, notes that there needs to be more funding given to the SEC to increase their performance and potential. He concurs with Starner, saying, “they need people who understand the markets and don’t need to learn the markets.”

There have also been a lot of comments lately about the markets being slanted and benefiting the few at the price of many. Bernie McSherry, senior vice president of strategic initiatives at Cuttone & Co., cites that the quantitative traders have been making out like bandits with some of the latest market structure changes at the expense of everyone else.

Some people hold the current SEC staff and its efforts in higher regard. Bill Uchimoto, shareholder in Buckanan Ingersoll & Rooney law firm, says that the recent enforcement changes are wonderful and that Schapiro has done a good job of streamlining some processes and cutting the red tape. He foresees more investor confidence in the markets if the SEC makes the necessary changes and there isn’t another scandal on its watch soon. “The market has gone up,” he says, “although that’s probably more economic forces.” At its current pace the Dow Jones Industrial Average looks like it could soon close above 10,000 for the first time since Oct. 3, 2008.

Uchimoto hopes the SEC will focus on protecting the capital markets going forward. He would like to see a more streamlined way to raise capital and for the SEC to make sure it has enough staff to turn around the associated registration statements.

Regardless of whether the SEC is able to change things in the market, real reforms need to be made before investors will come back to the market with open purse strings. And even with reforms, it might be too late. “‘Change’ is what you offer to stall meaningful reform and to merely appease. As such, do not count me among the believers that there is or will be much reform at the SEC. Sure, I expect change. But that is a verb best associated with light bulbs and toilet paper,” says Bill Singer, a securities attorney and shareholder at Stark and Stark.

Singer’s lack of optimism stems from the nine-month period that Schapiro has been in office and done little more than “catch-up and self-flagellation.” It also would have helped the SEC’s case if they had actually caught Madoff, Singer says. “We can only wonder where he would be today if he didn’t open his mouth and admit his guilt.”

So at best, if the SEC does go through some material changes and real reform, investors might be more confident and feel more secure investing. At worst, their actions may not make a difference.

Change You Can Believe In?

Forbes: The SEC is really cracking down on offenders in contrast to how they worked through most of the past 10 years, and they forced settlements with Bank of America, General Electric and Hank Greenberg, and for substantial amounts of money too. Now, my question to you is since the bubble is facilitated in part by lax enforcement, what sort of impact on markets do you feel a revitalized SEC should have?

Margaret Starner: Wait a minute, on the markets?

Forbes: Well, you know, thinking longer term. You know, if the SEC is much more vigilant and much more on the job, you know, how do you think that’ll impact how firms operate? How do you think it, what sort of impact might it have on markets, you know, looking out into the future?

Starner: Well, if you look–I don’t know, you want me jump in?

Bernie McSherry: Sure.

Starner: Well, obviously, the SEC or a lot of regulatory agencies to me are more reactive than proactive. And I think that’s really where we are today, they’re sort of reacting to the anger and the angst that everybody’s going through when you recognize how much there wasn’t a level playing field from the public’s point of view.

Obviously, to someone like myself who’s at the very retail level, I would think that if the SEC really can clean their act up and provide better oversight, then it’s a fairer game for clients of mine. You know, because it definitely, my type of clients are the ones who are the losers in a market that’s not on a level playing field. But I’m not optimistic because traditionally, they’ve hired mostly lawyers who have no experience in trading or anything that would help them even discover that Madoff was a crook. And so, I think that, you know, the lack of practical experience or street smarts is a challenge.

McSherry: Yeah, I also think that the government has to properly fund their efforts. I think they were understaffed and underfunded for quite some time. But I guess the real risk is that there’s an overreaction at some point in the not too distant future, perhaps it’s for political reasons, political grandstanding, but it’s clear that improvement has to come and anything that helps restore investor confidence is a positive in my opinion. And we certainly need some regulation in that area.

Starner: At minimum, they might start outsourcing to people who have the expertise to go after like, I read this one article where the SEC is reaching out to other intelligence agencies or other agencies just to sort through the data to find out if any of these chips are right. So, it was shocking to me that they didn’t have a system to go through to assess the data that they had.

McSherry: Right, and I think we’re gonna see some regulation of financial instruments that are currently not regulated. You know, we’ve all heard a lot of new acronyms and new names of things over the last year or two, and most of them were under the radar. It seems fairly clear that those instruments are going to be regulated and particularly risk indicators, systemic risk is going to be measured, and that’s probably a good thing for everybody.

Forbes: How are they going to do that, and which instruments are you thinking of specifically, Bernie?

McSherry: Well, things like there are a lot of things that are traded that weren’t traded in exchanges I think you’re gonna see a push to take some of these derivative instruments and drive them to exchange-type venues where they can be traded out in the open and regulated

I also think that you may see a movement toward a recentralization so to speak of markets. We’ve had a great fragmentation in the equity markets, for instance, over the last five to 10 years, you know, from a handful of market centers to.

Starner: You mean electronic trading stuff?

McSherry: Yeah, you know, we had a handful of market centers, and now we’ve got 30 or 35 dark pools and the like and it’s very difficult to regulate and coordinate information across that large number of institutions. And I suspect you’ll see some pressure both from an economic side and particularly from the regulatory side to merge some of those operations into a smaller number.

Starner: But it is a little disconcerting still to see that no one did anything about rapid trading until the Wall Street Journal or the New York Times brought it out.

McSherry: Well, I agree with you. One of the things that the New York Stock Exchange did when I was the governor there, we complained frequently about industry advances that were taking place that disadvantaged retail investors. And it seems to me that many of the changes that have taken place over the last 10 years have primarily been to benefited a small handful of quantitative traders at the expense of everybody else.

Forbes: What do you make of the impact of Robert Kazumi, who’s been brought in by Mary Schapiro and seems to really be, you know, applying the SEC as people say they want it to be applied, you know, in a very strong way?

McSherry: You know, I’m not as familiar with it as I should be, so I really can’t comment on that one.

Starner: Well, he was really more like the New York, more of investigative-type background. I’m not really sure, but I think though that, you know, the SEC does have a role in perspective and those types of things, and they probably do a pretty decent job in that area.

I just think that when they get a little more like, some of the stuff that’s a little more creative or fancy products, it’s really hard to know where their bounds are; they just don’t seem to know how to keep up with that.

Forbes: So in a sense, they’re suffering from mission creep, i.e., doing far more things than they’ve ever had to do in the past and not being up to the task of regulating all the new instruments under the sun.

Starner: Yeah, and they seem to be rewarded. Now, I’m reading this from the press, I don’t know if this is true but the people I talk to in the SEC, it seems to be they are rewarded for nitpicking things. You know, getting you on small things and all the audits they do and so forth. So, you know, the small guys get picked on all the time. I mean, I’m with a medium-sized firm, and I see what we go through, and it’s sort of amazing to me that someone like Madoff got away with it when I see what they pick on here.

Forbes: Right.

Starner: When they do the audits.

Forbes: Well, and Madoff’s deputy said that regulators would come to his office and sometimes ask for jobs on one or two occasions.

Starner: Oh my God.

McSherry: I think most of us have had experience at one time or another with a regulatory official or two who was fairly green and didn’t really understand what they were doing and asking us more questions about how to do their own job and what they should be looking for.

Starner: Yeah. Yeah.

McSherry: And it’s a little scary when that happens. But the reality is that the jobs pay considerably less than the ones of the people who are being audited. And people go where the money is, and the talented people leave.

Starner: But there’s no reason they couldn’t find a way to get around that. I mean, there’s a lot of talent they can outsource to and so forth.

Forbes: Well, getting back to the question, if the bubble was abetted by lax enforcement, you know, Bernie, and Margaret kind of answered this question, what kind of impact on markets should a strong SEC have on should will this help lead investors to come back? Will they have more confidence in markets if the SEC is on the job? Or do investors really not care?

Starner: I think investors definitely care, but if they don’t believe that having a simpler perspective is the answer.

McSherry: Yeah, I think confidence is essential, but it’s not just in terms of regulation, it’s just in terms of the viability of the markets, the accuracy of the data, the way there have been questions asked recently about whether we’re getting true data out of the governments, that there’s a great incentive to paint a rosy picture.

So, there’s confidence on lots and lots of levels. I do think that an improvement in regulation and an increase in regulation will help investors feel more comfortable about the markets. But the markets are incredibly complex, and it’s going to be difficult for us to anticipate every possible problem.

Starner: But to some degree, all the some of the issues have become too politicized probably.

Forbes: Are you thinking of anyone in particular?

Starner: Well, I just think that the whole going toward not having a balance between more a free market and a market that’s protected the investors.

Forbes: Where are we now, you think?

Starner: I think there’s a little confusion as to where we are now. I definitely think Schapiro’s on the right track. I think she has a sense of her mission. But there’s a lot of infighting, at least according to what we read and hear, between the agencies over who’s gonna do what. Do we need another agency? Probably not. I mean, we don’t probably need to add another agency. Pardon me.

McSherry: We could probably merge a few of the ones that we have actually.

Starner: Yeah. Right.

***

Intelligent Investing

Rich, Spoiled, Young Adults

Carol Pepper, 12.02.09, 12:00 PM EST

Use your money to turn your young adults into good people.

Once wealthy teens make it to adulthood, they introduce a whole new host of issues to their parents. Now we really have to be on guard against exerting negative control with the family wealth.

The first issue is to level with the young adult about what he or she can expect from you in terms of financial support. This is a very personal issue. Some parents create large trust funds that give children enough to live on without working; others choose to leave all their money to charity and expect kids to create their own fortune. The most important thing here is to be honest with the young person about what to expect and not to try to use money to exert negative control. This is the number one mistake that wealthy parents make, and it always backfires. You can no longer exert the type of control you did when your child was under the age of 18; now he or she is a legal adult, and the sooner you treat them as such, the higher the chances are that the relationship will survive.

The first principal to employ here is honesty and consistency. Do not dangle money in front of your young adult to get him or her to do what you want. They may temporarily comply to get the money, but they will always break the deal once they have the cash. And they will hate you for putting them in such a terrible position. Read my novel, Beyond Blood, if you want to see how bad this can get. There is no reason that you cannot set terms for them to receive funds, but make the terms fair and do not change them later. You will end up losing the relationship with your young adult completely. Not to mention you may end up in lawsuits, exposing family secrets to the gleeful media.

Many parents become upset if their young adult marries someone that they do not approve of. This spouse may be of a different race or religion, or may just be socially unsuitable in the family’s eyes. The spouse may be of the same gender, which can be very hard for conservative families to accept. It is your right to decide not to fund your young adult at the same level if you do not like his or her spouse. However, this decision should be made only after deep deliberation–it is extremely sad to put the young adult in this situation and risk never seeing your grandchildren.

Again, trying to stop an undesirable marriage by withholding funds rarely works. If you are truly concerned that your young adult is marrying a fortune hunter, it is important to try to protect him or her by encouraging the use of a prenuptial agreement and segregating assets into trusts before the marriage occurs so that they do not become marital property. Your young adult will thank you later if the marriage turns out to be a sham.

The most frustrating young adult to deal with is the perpetual adolescent who refuses to grow up. This is the kid who will not work, constantly whines for money and never feels he or she is getting enough. The key with this type of young person is to set limits and stick to them; otherwise you are in for a lifetime of emotional blackmail. If the underlying cause of the young adult’s behavior is depression or drug abuse, intervene early and insist on treatment. The longer the young adult remains in a dependent state, the harder it will be to break the pattern. If you do reluctantly decide that you will be forced to support this person for the rest of his or her life, you are well advised to place the assets in trusthe or she will still need a parental figure to control their access to wealth after you are gone.

The easiest and best situation you can hope for is that your young adult has made the transition to living responsibly and you are now free to become friends. It is a joy to share the enthusiasms, hopes and dreams of young people just starting out and to remember these times from your own life. Families are often blessed with young adults who want to learn and eventually take over the family business. The relationship can move from one of control to one of partnership and emotional support. This is the best return on investment one can hope for.

The Panel Interview

2010 Will Be Fine

Paul Maidment: Carol, what do you think is going to be the most dominant trend for investors in 2010?

Carol Pepper: I think investors are going to be pleasantly surprised by 2010. The fear that we experienced in 2008 and 2009 will really start to dissipate. The trauma, the remembrance of trauma will start to fade. And I think we’ll see a continuation of this recovery, which will mean more investors coming back into the market, will mean continuing rally in the stock markets, which will be exciting for people. They’ll be glad to see.

They’ll start to regain all those losses that they had in 2008. And I think there will be a general tone of positive feeling, relief, and a desire to perhaps re-risk the portfolio. Although I do think that people will continue to be wise and not go as crazy as they did in the past. And realize, “OK, it’s time to go back in. But to really pay attention to my asset allocation, and make sure that I’m only going into the extent that it makes sense for my own particular risk parameters.”

Maidment: Bernie, you like the momentum of crowds. Is that a view you share of what 2010 is going to be like?

Bernie McSherry: Yeah, I think, ultimately, it will work out fine. But I am concerned about any unanticipated events that might come along in the first half of the year. I don’t think everybody is quite over last year. And I think that there’s the possibility that people really don’t believe in buy and hold right now. And the conviction, I think, is very, very, very shallow. And I think the first signs of trouble, we could get a little of a stampede out of the market. We could get a dip early. We will have to see how it plays out.

Maidment: Chris, from your perspective, does that seem like how 2010 will work out?

Christopher Hyzy: Yeah, I completely agree. Actually, right in the middle of both Bernie and Carol, for the big reason that, you know, the markets care about one thing for the most part. They care about a ton of things, but the biggest thing they care about is: Are you going to improve tomorrow, the next month, the next quarter on what you’re living through now? And I think the general answer to that is yes, across the board on many instances. There’s a lot of long-term headwinds out there. We know that. The deficit, whether or not the dollar is going to continue to weaken. And actually, it’s probably a good thing in the short term. But just generally speaking, we’re going from [a] rescue-and-repair type of an environment to a recovery environment.

And that’s a good thing. And the markets will applaud that. And there’s still a ton of cash on the sidelines, regardless of whether or not we’ve bounced 60% to 65% off the lows. It’s good to talk about in terms of numbers, and we all feel good about it. But 0% earning cash is the greatest fuel to an equity market rally.

Maidment: We’ve certainly been assuming in those answers that we’re talking about equity markets here. But if you look what’s been happening recently coming out of 2009, a lot of money going into commodities, and particularly into gold. How would you see gold performing next year?

Hyzy: You know, gold is always perceived to be a store of value. It’s actually quite the contrary, actually. It is probably the best hedge on a declined, continued decline in the dollar. And the way we look at gold is not necessarily as an investment; it’s a protection strategy. And an allocation to gold in a portfolio, for most investors, is a very prudent thing. So from the standpoint of prices and things like that, you know, we’re still a ways away from inflation-adjusted highs at something like $2,800 an ounce back in 1980. It’s good to talk about new highs, non-inflation-adjusted right now. But at the end of the day, it’s a protection strategy. So from our clients, from investors’ perspective, I think it’s a great hedge. I’m just not so sure about a continued directional investment upward in some, you know, in the metal of gold.

A Dollar Rally?

Maidment: Bernie, let’s look at the dollar then. You would expect that to be, continue to be weak if gold’s going to be reasonably strong. What’s your outlook?

McSherry: Yeah, you know, I think the surprise of the year may turn out to be a rally in the dollar. I think it’s the most crowded short trade that I’ve seen in quite some time. Everybody’s short the dollar. At some point, we’re going to get some good news about the economy. We’re starting to see it trickle in. And as the year goes on, the Fed will be signaling some kind of a tightening cycle.

They may not, perhaps, raise rates so early in the year, but they’ll be starting to unwind some of those quantitative measures they’ve taken. I think when that happens, you could get a really violent move in terms of a cover. I think you could get a rally in the dollar.

Pepper: And we have, we can’t just discount what’s happened in Dubai. It’s sort of been looked at as something that was a hiccup. First, everybody got very scared for a few days. Now everybody is thinking, “Oh, it’s nothing.” But we’re not quite sure yet what it is exactly. And if Dubai turns out to be a bigger problem than we think, if it’s, there’s more contagion in the emerging markets again, suddenly, that could affect the dollar as well and send people scuttling back to a safe haven.

I’d also like to add on gold–investors should be careful buying at $1,200 an ounce. That’s a very high price. They’d be better off to wait a little bit. I think $1,000 is a better level, [an] entry-point level. I do think, perhaps, over in the next three or four years, you might see it … continue to rise. But right now, we’re, there’s a bit of a speculative frenzy. Even today, the Bank of China warned about that, and said that they’re not buying on this and these prices. So the little guy, the regular investor, should be careful buying gold at this level right now.

We Need Loans

Maidment: That mention of Dubai, though. I mean, a lot of the sense of contagion there was spread because of the banks’ exposures, which is a way of segueing, maybe, into banks and financial stocks for next year. What’s your outlook on those?

Pepper: Well, I think banks have done extremely well in terms of getting government funding now. Today, we found out that
Bank of America
is going to be repaying their TARP debt. I think that you’re going to see banks start to recover. What we haven’t seen yet is banks starting to lend again.

And again, they really do need to be prodded with a pitchfork, I think, to get them out there and start lending again. They’re still concerned about lending because they’re still afraid they’ve got a lot of toxic loans on their books. But as the recovery becomes more real or seems more real to people, hopefully, that will encourage banks to not feel that they have to reserve so much against potential loan losses and will get the lending going. That’s something we really need. That’s really the missing piece. Once we see the lending starting to happen again, that’s when that’s going to help small business. That’s going to help a lot of sectors of the economy that are a bit left behind right now, like employment, to start to move.

Maidment: Bernie, you talked earlier about, you know, expecting the unexpected. I mean, do you see any other nasty shoes dropping in the banking and financial sector?

McSherry: Well, I think particularly the regional banks still have a lot of exposure in commercial real estate, and we don’t really know how bad that’s going to be. Certainly, anecdotal evidence indicates that it’s going to be serious, and some of the banks will ride it out better than others. I think one thing that we’re going to have to look at going forward is the fact that people have gotten used to the idea of the government being willing to come to the rescue of just about anybody who needs it. And I think we’re going to recognize that that’s not going to be the case going forward. I think folks in power recognize that mortal hazard is a cancer in the economy and they’ve got to cut it out. And they’ve got to stop it. And I think we’re going to have to deal with a new set of assumptions about who is going to be saved, and who is not going to be.

Maidment: Chris, do you think “too big to fail” is gone? Is it dead as of last week?

Hyzy: I’m not so sure that “too big to fail” is ever going to be gone, whether you’re talking about banks, financials or any other sector. You know, 10 years from now, we’ll see this again in something else. But perhaps, and hopefully, not as destructive. But I would say from the banks and financials’ perspective, in terms of what Bernie and Carol just said, absolutely spot on. The regionals, the small, local, community banks. More pain with commercial property. But the difference, overall, last year vs. heading in, you know, this year heading into ’10 is the unknown vs. the known. We know where the potential pain points are going to be further. You know, commercial property we talked about.

Provisions set aside against delinquencies and defaults. The surprise factor, however, is to the upside. Steep yield curve, better-flowing credit markets. Capital markets are freely flowing on their own. Not government-assisted anymore. And more importantly, you’re going into a situation where some of the provisions that were set aside actually are too high for the delinquencies and defaults that come through, and that’s a positive earnings surprise. So actually, it’s a very important sector to watch. I would not be overweight right now because of where the companies are, but it’s certainly the swing factor sector going into 2010.

Tight Policy, Not High Rates

Maidment: Any concern that the Fed will raise rates in 2010 or will start to pull out some of that money that’s been very good for the banks’ profits this year?

Hyzy: Yeah, it’s a very important topic. It’s talked about a lot. But what the point that’s not talked about is there’s a difference between tightening policy and raising rates. And tightening policy could simply just be removing some of the training wheels that were out there. And we’re going to see that sooner rather than later. They’re already starting to do practice reverse repos out there. And that’s actually a really good thing. Raising rates, however, before we’re in full recovery mode, which is not really likely to happen until 2011, is something where a policy error would cause us to kind of go backwards.

And that and I just see–I can’t see that happening in 2010.

Maidment: Carol, do you see the Fed encouraging more lending to medium and small businesses? And are there any risks to the banking sector in that happening?

Pepper: I don’t think there’s risk to the banking sector. There’s a lot of very good small businesses right now that are perfectly financeable 16 months ago that haven’t been able to get credit for the last 15 to 20. There’s nothing wrong with the companies. The, it was really other problems that caused the banks to pull in their horns on the small businesses. I’m not sure what it’s going to take to get the banks to lend to them still.

As I said, it may take just a bit more time, and then feeling more comfortable and being able to, as we said, reduce the loan loss reserves. But that’s really what we need to see happening. And once that happens, I think you’ll see a big uptick in employment. Because suddenly those folks will have the money and the confidence to go start hiring. It’s not that they don’t need workers. They do. It’s just they don’t, they can’t rely on the financing lines to be there to help them when things are going up and down in their normal business cycles. So that’s what we need.

Maidment: Carol, what are you advising your clients to look at? What sort of strategies for their own personal investments for 2010?

Pepper: Well, it’s funny. You know, two years ago, we were, everybody was in panic, and they just wanted to sell everything. And they were hysterical. Now what we have to do, I think, in 2010 a little bit is going to be to rein in the optimism, and keep people within their asset allocation. Because yes, we’re going to, I think we’re going to have a fantastic year, but that doesn’t mean you should go out and put your entire portfolio into China and Hong Kong.

It’s not a good idea. So remaining disciplined, and enjoying the rally in the parts of your portfolio that are fully invested in the markets, and in the risk assets will be great. But just as important will be keeping the part of your portfolio safe that needs to be kept safe, so that when the inevitable happens, which will be some kind of surprise or some kind of dip or some kind of, you know, could be an act of war. God only knows what, and the markets have a crash again. The clients, will be safe. So it’s, you know, the, you, there’s always and I know, Bernie, you’re really into market psychology. There’s always this over-exuberance, and then over-terror. And what we’re trying to do is keep clients in the middle way, you know? Aristotle was right. The middle way is always best.

Avoid Extremes

Maidment: Chris, I mean, can you apply what you’re telling your clients, I mean, obviously, professional investors, in a way that would apply to the individual investor?

Hyzy: Yeah, absolutely. You know, in the middle is a great phrase. Typically, you don’t want to be the middle child, but in the middle in investing going into 2010, possibly 2011, it’s the right thing. And it means so many different things. But from our perspective, do not be on the extremes. Not all cash and fixed income. Not all equities. It’s never all-in. It’s a diversified risk-budgeting approach or on a set policy benchmark that you have for, in Bernie’s type of methodology.

Manage your investment risk, and the interplay between that and your wealth aspirations. And that’s the key. And, you know, economics is a behavioral finance, so why not use that in investment management? And at the end of the day, it’s an upward tilt on an overweight basis to reflationary assets led by equities, the emerging markets, commodities, tangible assets. But as you start to get through this recovery, you’re going to have to pare that back and down, back down to your policy benchmarks. And rebalance and be diversified as much as possible.

Maidment: Bernie, if you were filling your 401(k) or advising anyone to do the same, would you follow that sort of strategy?

McSherry: Yeah, you know, I don’t advise individuals. I trade on the stock exchange floor for institutional clients for many years. But, you know, you look at your own money. You look at your family and your friends. And I think we all learned a lesson over the last year about our own risk tolerance. We all said we had a tolerance for moderate to high risk, and we all felt good about it, but until the markets started to roll over. And I think people realized at that moment maybe they weren’t as committed to it as they thought they were. So, I think people have to reassess their own personal risk tolerance, and they have to get in the habit of rebalancing their portfolios. The days of taking your money and shipping it off to somebody to keep an eye on and never opening up your statements, those are over. You’ve got to actually have an active role in it. You’ve got to take a look at what’s being done with your money, and make sure that it’s being invested in a way that you agree with.

Maidment: Carol, have you seen a change in that sort of behavior amongst the people you deal with?

Pepper: Absolutely. In fact, there’s a number of surveys that have come out about wealthy investors around the world. So we actually have hard data on this area. And right now, for example, there was a survey done by Barclays Wealth by the Economist. Ninety percent of people saw a huge opportunity in the drop in the asset prices, but only 20% intended to take advantage of it.

So, I think the wealthier investors have actually be, are more conservative than the average investor who has, like, sort of shrugged it off, and is perhaps starting to go back into the market. Wealthy investors are still being quite cautious. They’re avoiding hedge funds. They’re avoiding private equity. They’re avoiding investments with a lot of lock-ups. They’re avoiding structured products. They’re avoiding financial engineering, and it’s very much a back to basics. Let’s look for liquid investments. And they know darn well that if things start to turn, and don’t go the way their investors, investment advisors say they’re going to go, they can get out. That’s the major attitude right now is, “OK, I’m going to trust you to a certain level, but I want to know that if things don’t go the way you say they will, I can leave.” And that’s where we’re going.

Hyzy: Big data point to emphasize what Carol just said is you have various statistics out there saying anywhere between $10 to $15 in cash and fixed-income money in flows vs. $1 in equity flows into the markets in 2009. But yet the equity markets are up from their lows 60% to 65%.

Pepper: Yeah.

Money on the Sidelines

Maidment: So is that implying what? There’s a lot of money waiting on the sidelines that–

McSherry: I think certainly a lot on the sidelines.

Maidment: That will go into equities?

McSherry: It probably will going forward. But I think people are getting used to carrying a lot more cash. I think the events of the last 14 months have shown people that they’ve got to have some liquidity to ride out what could be a two- or a three- or four-year problem. And people are going to hold that cash for a lot longer than we expected.

Pepper: There’s a model that we used to talk about way back when that I think is going to become much more interesting to people nowadays. And that’s the good old barbell, where you have a huge amount of, you know, half of your money in cash and short-term Treasuries, and half of your money invested. And it’s makes people feel a lot safer. Or at least the end of the barbell that has the cash and fixed income is enough to cover your living expenses and your emergency funds.

So, it’s going to be very different from the days when we had only 20%–10%, 15%, 20% in cash and fixed income.

RiskManagement

Maidment: And Chris, do you, I mean, do you see the same aversion to risk that we’ve been talking about applying to debt as well? Do you think the individual investor is getting is far more debt-adverse than they were certainly before the financial crisis?

Hyzy: In many episodes. Yeah. I mean, we talked about a swing factor before, in terms of sectors and in terms of what will drive the economy. But as it relates to actual investment in asset classes, the swing factor, when you look at cash and fixed income. We mentioned the fund flows before. That’s one data point.

The second data point is look where spreads and yields are. The yield will be in equities, in our opinion, in the next year, two years, or however long that the policy remains the way it is. So by default, you’re going to get frustrated cash money doing two things. Looking for distressed opportunities in areas that the first approach was fixed income. We saw that already. The second approach will be in true businesses. Buying businesses, buying property, etc., whether it’s in the United States or elsewhere. And the second one will be in value inherent in the equity market. And you’ll start to see movement go into large-cap, multi-national companies, and dividend-producing companies, etc.. Because that’s where the yield will be, as long as the term structure of interest rates stays low. So I think that story has been told. There won’t be a lot of en masse movement out of fixed income because you need it for matching future liabilities, but in this, the marginal dollar investment is coming out of there.

LookOutside the U.S.

Maidment: And where would you strike the balance between domestic U.S. investment and international investing?

Hyzy: You know, in the very, very short-term, Carol mentioned before, barbell. We deploy a barbell in equities. Simply put, it’s large-cap, multinational U.S. companies and it’s emerging-market companies. And all the stuff in the middle, whether it’s developed Europe, Japan, etc. They’re going to have a hard time figuring things out.

The flexibility is not there. The dynamics aren’t there. Emerging markets is a cyclical recovery story and a secular growth shift. The U.S., on the other hand, is a repair story with yield in those balance sheets of high quality companies. So we think it’s a great barbell. It makes sense. And the split, quite frankly, should be further and further towards 50/50, as it relates to non-U.S. vs. U.S. than ever before.

Maidment: And you would be advising the individual investor then to direct investment in equities in the U.S., but through funds for international investments?

Hyzy: You know, for those that have the risk tolerance to build a customized portfolio around individual securities outside the United States, certainly that’s appropriate for some people. But as it relates to where alpha can be produced when you look at all asset classes, emerging markets and small-caps is still where you can get alpha in a managed approach. On the indexation side, tax-efficient side, still a large-cappering of the U.S. is you can deploy into ETFs and some other strategies.

Maidment: But you got to have the appetite for risk if you’re going to go internationally right now?

Hyzy: That’s right.

Maidment: Carol, let’s talk a little bit about the tax considerations that investors should be looking at in 2010. What are you, again, advising your wealthy clients?

Pepper: I, well, always, clients to try to minimize the amount of taxes that they have to pay by being smart. What does that mean? A lot of them had a lot of losses that they could harvest, so now this year they can shelter some of those losses. They may have losses that are carrying forward from the last couple years. That’s a very good thing. So some people were advised to take some of those losses, by the way, where they could use it going forward.

I think that’s a smart thing to do. I think looking at your vehicles that are holding your assets. So, simple things that even aren’t necessarily to do with the current tax administration, the fear that taxes are going to go up, but having a revocable living trust, for example, to hold your assets to protect you from probate. These are sensible things that people should be doing anyway, and make even more sense as we go forward. So, basically, the message is the same. Be smart. Get good tax advice, and in my opinion, don’t go out toward the edge, and do something that looks a little bit dodgy because the government will find you. The
UBS
case that we just went through where UBS was forced to reveal the names of U.S. taxpayers shocked the world has, is a huge topic among the wealthy.

But I think the message there is just be conservative in your tax strategies. Don’t go after the latest insurance product wrapped in a, you know, a life insurance, sitting offshore, if you’re an American person. That is not a good idea. The government will come and find you.

Maidment: And anything you expect coming out of Washington in 2010 that will change the tax regime in any way that investors need to be very often.

Pepper: There’s a lot of talk about different things, but I haven’t heard anything that is specifically coming out in 2010. I think there’s a lot of negotiation going on. I think until we get the health bill passed, and we see what that’s going to do, that’s the focus, in my opinion, of the administration right now is to get that passed.

Once we’ve got that done, they’re going to turn their attention to everything else. But that’s their number one priority right now is to get health care passed.

McSherry: Yeah, I agree. There’s a lot on the legislative agenda right now. I think it’s a stretch for them to try to raise taxes at this time, so I don’t expect to see anything until next year.

Pepper: Yeah.

Maidment: Let’s go around the table again; just one question this time. And what’s the one smart piece of advice you’d give to any individual investor for 2010? Bernie, why don’t you lead us off?

Maidment: Carol, what, from the perspective of your wealthy clients, what is their outlook on the housing market?

Pepper: Well, it’s interesting. I think that people, for example, that can afford not to sell their homes in the last couple of years, I’m thinking of the folks that had the mansions out in the Hamptons, just pulled them off the market, and they’re waiting. There’s a feeling that the market will recover. In the higher-end market, of course, the bonus situation on Wall Street is probably going to be better this year than expected, and that may mean that the Hamptons and the higher-end real estate in Manhattan will start to recover.

And in places like Florida and some of these distressed markets, Los Angeles, California–I mean, Las Vegas. They’re been buying. Because there’s a feeling that, you know, this is probably a once in 20-year opportunity to go out and buy some very distressed assets. So for people that have cash, they have been very excited to go out and pick up, you know, incredible pieces of real estate for very little money. For the folks that levered themselves up to get into the real estate game, and a lot of those folks at the more middle-income point of the market, those people got hurt. A lot of them have gone bankrupt. They couldn’t carry their asset long enough. They didn’t have the cash flow, and the banks pulled in the credit. Those folks dropped out the game, so it’s been a real sense of winners and losers. The winners being the people with cash, who could go in and swoop in, and take the assets off the table. The losers being the people who couldn’t hold on long enough till the game turned around.

No MoreHouse Flipping

Maidment: Bernie, how do you play this as an investment play in 2010–construction and real estate?

McSherry: Well, I’d like to think of it more as individuals, that you were talking about winners. I think the winners right now are young folks out there, young people who are starting families. We’ve got 30-year mortgage rates, I think I saw 4.75% this morning. When I was getting started in my life as an adult, I remember 17% mortgage rates. So they’re–not only are prices low, but financing is available. So I think people have got to get out there and take advantage of that.

Hyzy: You know, Bernie, it’s a good point there. We all talk about deleveraging. There’s a few ways to deleverage, and it’s just simply paying down liabilities, right? It’s painful. You’ve got to take good cash, productive cash, and put it to so-called unproductive use by paying down liabilities. But there’s also a second part of it, which is replacing old, high-volume, higher cost of debt with new, lower-volume, lower cost of debt. And that’s what’s going on right now. And you benefit a whole portion of society, which, again, you’re not seeing it yet. And it’s very painful for Main Street to hear that people are constructive on real estate or on the economy because they haven’t seen it yet, but it’s coming. And it’s a step in the right direction each time we get through from quarter to quarter. And just in general on real estate, you’ve got the residential market.

You’ve got the commercial property market. The residential market is a little bit ahead of the game. Obviously, they took most of the pain. The foreclosure problem is still going to be there, but you’re starting to see some good signs, like Carol said, in the distressed markets that led us into the downturn. And I think more importantly, overall, what you’re going to miss is the trade-up factor. You’re not going to see those investors who are hoping to trade up to a new home and sell their other one. That’s gone. We’re back to 1990s real estate again, which is, “I own a home for a utility, quality-of-life perspective. I’m not looking to trade it.”

Maidment: Carol, do you think that attitude, that change of perspective about the purpose of home ownership, is that something you’re seeing as well?

Pepper: Well, I think, again, the average person can’t go in and play the game that they did. You know, all those seminars about, “Become a multi-millionaire by buying a lot of property.” Or Flip This House, you know, used to be [on] Home and Garden TV. Now we’ve got Sell This Loser. You know, it’s really changed. I think people are a lot more leery. They’re realizing that real estate isn’t a liquid asset. There are times when it’s very liquid, but the cycles are very, very long. So that’s something that Main Street had to learn. Again, for the wealthy, they’re in a different category. And in their case, they’re loving this time because they’re buying, you know, they’re continuing, and frankly, have never been all that affected by a lot of things that happened. And they’re seeing this as a great time to pick up some incredible properties that perhaps have never been on the market.

So, it’s a very mixed bag. And I do think for Main Street, you know, those people that are, there are still people I know that are thinking about whether they should bankrupt themselves, and just get out from under all these mortgages. They’re struggling to carry on every month. My strong advice is do not do that. Wait another six months. You’re going to be able to sell these properties. Try to not go into that bankruptcy thing. Because I think that’s a big mistake. People right now, it’s interesting. Right now, just as we professionals see that we’re coming out of this, there’s a lot of people on Main Street who are just starting to give up right now. They’re like, “I can’t take it anymore. I can’t hold on for another six months or a year.” And my strong message is please don’t do that. Wait. You’re going to get through this period, and you’re going to be very glad you didn’t bankrupt.

Commercial Overhang

Maidment: OK. Let’s switch for a moment from residential to commercial. Bernie, how toxic is commercial real estate at the moment?

McSherry: Drive around any town near where you live. A third of the storefronts are empty, I suspect, so I don’t think we’re getting out of this problem for a while.

Maidment: Is that going to be an overhang on the markets?

McSherry: Yeah, it is. Particularly, we talked about the regional banks earlier. But I think it is going to be an overhang on the markets. And it’s not just in terms of the market itself, but just construction. Construction is not going to be recovering any time soon, in my opinion. At least not as a segment. Getting back to the residential sector, you know, the McMansions of the world. You can buy them now for cheaper than what it would cost to build one, so that’s going to be an overhang on that industry for quite some time. Replacement value, you know, it’s an issue.

Maidment: Chris, are you as sanguine about the industry as Bernie isn’t?

Hyzy: You know, I would say a few things. Commercial property, traditionally, is always a lagging asset class, a lagging indicator, etc.. We all know that. It’s the known vs. the unknown. It’s going to lag further this year. You know, given the securitization of debt, etc., to fuel that. You have to break it down, too, though. You have to look at the storefronts that Bernie talked about. Retail office construction, industrial, etc.. There are some very good signs in commercial property, particularly industrials and some other areas due to the manufacturing pickup. The retail, the storefronts, the consumer who’s going to save more, spend less. That’s yesterday’s story. The retail, you know, we still have too many retailers out there. Vacancies are going to go up. Rental prices are going to go down. Eighty percent of the failed institutions was 120 or so this year were due to some situation in commercial property.

That’s going to continue. We know that. That’s kind of the good point. We know that. And then there’s some built-in stabilizers. The Fed program. You know, buying legacy loans in the CMBS [commercial mortgage-backed securities] market, not just newly issued loans, etc.. It’s gotten to a poor start, in terms of the dollars set aside, but it’ll start to pick up. And I think when you head into the latter part of 2011, we’ll look back and say, “It was longer than we expected, but we’re through it.” And, you know, that’s another year and a half or so.

Maidment: OK. We have a minute left. So, let’s go around the table once more. And perhaps we could advise the individual investor, the one smart thing to do about real estate in 2010? Bernie, lead us off.

McSherry: I’m a big believer in paying down your personal debt. We all learned a difficult lesson about being overleveraged. If you’ve got some extra cash, get that mortgage down. Refinance it if you possibly can. Lock these rates in, and then you really don’t have to worry about it. You can just live there and enjoy your home.

Maidment: Chris?

Hyzy: I would agree with Bernie on the personal side, in terms of the individual. In terms of the investor, I would say patience is going to be rewarded. I would say high liquid investors right now, as Carol said before, they’re a little bit happy. And they’re looking for prime properties [that] at the right price will sell and will be a good investment. So be patient. And if there’s one thing we know about the real estate market, it is location, but it’s also knowing who your seller is, too.

Maidment: Carol, the last word?

Pepper: Well, as I said, I think that the average person should not hang in there another six months. Keep paying those bills, and you’ll be able to sell your properties. Don’t just turn in the keys if you can possibly help it. And for those who can afford it, this is a once-in-a-lifetime opportunity to get some fantastic properties at a good price.

Maidment: Thank you very much.

2010 Outlook

Maidment: Bernie, what’s your outlook for the economy in 2010?

McSherry: I think we’re going to do well, generally. But I think it’s not going to be a smooth, straight line. I think, well, we’ve gone a little complacent in terms of how the markets performed over the last six months. People have gotten used to a fairly steady incline, and I think that we have to acknowledge that there are still some risks out there.

I think, overall, we’ll do well. But I’m concerned about some of the hangovers still from real estate that are out there. I think people, individually, are still feeling their wealth has been crimped. Their recovering some of their portfolio values, but until housing and jobs come around, I think we’re going to have some difficulty early in the year.

Maidment: Chris, is this a new asset bubble, then, that we’re having created by all the money that Central Bank is pumping into the global economy or have we still got to see the collapse of, as Bernie indicated, existing bubbles like commercial real estate?

Hyzy: You know, and we mentioned bubbles before. In the ’70s, you had, you know, Japan. In the ’70s, you had natural resources. In the ’80s, you had Japan. In ’90s, you had Nasdaq or, perhaps U.S. equities and general tech, tech-Internet space. In 2000s, it was leverage. So, we’re unwinding that. That’s without question. The next bubble is likely to be in natural resources again, going back to a thirty-year-ago period. Simply, but it’s a demand-led bubble. It’s not a supply constraint-led bubble. It’s a little bit of both.

So, are we going to unwind the leverage bubble still? Yes. Are we building a new one? Without question we are. But when we look back ten years, that’s when we can confirm that. The here and now, in terms of the economy, it’s all about jobs. The market will head higher if we can show that we’re increasing jobs.

Our view is that by the end of the first quarter, you will see job growth. It’s going to be a big surprise. The consumer is repairing their balance sheets faster than what Main Street is seeing yet. But when Main Street gets comfortable, that’s when Wall Street does, and that’s likely to happen by the end of the first quarter.

So, we feel very good. And more with Bernie, cautious, but at the same time, the consensus has it wrong in our opinion. Above three percent growth in the U.S. Above four percent growth globally for next year.

Maidment: Carol, do you think that’s too rosy an outlook for the future?

Pepper: No.

Job Creation

Maidment: Can the Fed generate the jobs?

Pepper: Well, I think the Fed will not generate the jobs. I think business will generate the jobs. As we discussed earlier, if we can have credit loosening, so that businesses can have their lines of credit back, then they are going to feel more confident, and they can start producing the jobs. Usually, as we know, the market, the stock market leads the real economy by at least six months, sometimes nine months.

So, I think the stock market is signaling the fact that, you know, by, let’s say the summer, I think at the latest, we’ll, you know, maybe the first quarter will have the job growth. It might not be until the summer. But definitely, you know, there, everybody has run through their inventories. They’ve got to rebuild inventories. You know, so many people are doing three jobs at the same time, so I think there’s a lot of possibility that rehiring will finally start to happen. And that’s, you know, what we need.

But frankly, companies have the reason that profitability has been up, too, is that they’ve been able to keep the payrolls lower. And they’ve been able to increase, squeeze productivity a bit. So I’m not sure that they’ll necessarily be rehiring the same individuals. However, there’s a huge area that, you know, again, we haven’t seen the money go into it yet as strongly as we’d like. But the stimulus put money out there to do green jobs, and to start retrofitting buildings, and start redoing the grid and redoing the infrastructure of the country. We may see some of the job growth going there vs. necessarily existing companies rehiring old workers, so we may see new industries starting to spring up. That’s just a machine that has taken a lot longer to get jumpstarted and going than it took a year from when the administration was elected.

Maidment: But Bernie, I mean, can we, is it sustainable to essentially run economic recovery on the basis of money being pumped into the economy?

McSherry: Well, that’s what I’m worried about actually. I think the economy is recovering, and jobs are starting to come back. But the folks down in Washington aren’t very patient. And there’s a lot of outrage on the public, and people are demanding something to be done. And President Obama is having a job summit being held, which is conveniently around the time that things seem to be starting to get better, so they’ll be able to take some credit for that as it goes over the next few months.

But I think there’s a good likelihood we’re going to see some kind of a second stimulus. It won’t be called stimulus because I don’t think it’s politically palatable right now, but they’ll be some kind of jobs package put together, which will probably deliver jobs after they’ve already been created elsewhere. So, we may not need it, but we’re going to get it.

Maidment: Chris, do you think that’s likely?

Hyzy: You know, I’m a little skeptical on a second stimulus. But I agree with Bernie on the game plan, which is it may not be called stimulus, but it will certainly be, you know, couched in a different manner. But I think they should be patient on it for the very simple fact that we’re working off of a positive feedback loop right now, not a negative feedback loop where we were back in the early part of ’09.

And the positive feedback loop is you get unemployment peaking. Temporary requests are going up right now, temporary worker requests. Hours worked are going up. Compensation, for the first time, is up quarter over quarter, as it relates to full compensation. Those are the initial signs that jobs are going to start to be hired.

But the headwinds this time around are the health care situation, the potential tax policy changes. So, Corporate America is sitting there waiting. “We need to know what’s going on. What’s the game plan from the government?” That’s the first thing. The second thing is they’re flush with cash. They’ve destocked inventories. The ex-financial sectors are extremely healthy, so we’ll start to see some hiring picking up there, and that’ll create a positive feedback loop. Unemployment will start to come down. And then, oh by the way, maybe if they wait a little bit, they’ll see that this recovery is starting to take hold. And it’s private sector-led, not government induced.

Maidment: Most of the job creation so far, though, has been in the government sector. And I’m wondering if we are going to get this job recovery that you foresee, unless we can free the logjam on lending to small and medium-sized businesses? I mean, they still seem deeply thawed. I mean, not thawed, but deeply stuck in a credit freeze?

Hyzy: No question about it. Obviously, they can’t tap into the capital markets like the large companies can. So they have to go to banks for financing, etc.. We mentioned the positive feedback loop before. Once you start to see that this recovery is taking hold, inventories are starting to be rebuilt, and the export market is still working for the U.S.

The small business segment will start to hire again. The banks from there will start to say, “It’s OK to lend to you now.” And it’ll create this loop. It will not be like old times. You’re not going to see auto sales back at, you know, 17 million on an annual basis. Or new home sales at one and a half.

But moving from the nadir where we were back in March, or the trough where we were, to a 50% movement upward to 800,000 or 12 million in auto sales is a power move in jobs. We fell off a cliff last year in the third and fourth quarter. And now this is simply getting back to sea level, waiting for the next expansion, which is really not until ’11, ’12.

Maidment: Carol, do you see America creating this sort of new source of jobs that are needed for this sort of economy that we’ve been describing?

Pepper: I think so. I mean, I think that the great thing about having President Obama in place is that he very much understands the new economy, and he very much understands the international world stage. And he’s very well regarded out there, which gives us a positive headwind with the rest of the world that we haven’t had. He’s in sync, for example, with all of the sort of global agreement on greenhouse gases and carbon footprints and things of this nature, which, again, I think can cause the investment to start to really happen in the private sector.

There’s a lot of areas where Americans’ ability to create innovative projects, products, and technology can really work for us, particularly in green technology. The entire planet is starting to go green. I was just in Hong Kong lecturing. I’m going to be in Zürich next week. And I can tell you, the rest of the world is talking about retrofitting their buildings, clean water. All of these things require technology, and we are excellent at creating great technology. We have all these out-of-work auto workers who can be making windmills, and retrofitting buildings, etc.. So I do think that the administration is very much in sync with where the potential job growth can be right now, and that’s a positive. And hopefully that we’ll start to see those jobs start to happen.

China: Energy and Exports

Maidment: Bernie, do you think that it’s sort of just good American know-how in that sort of area can outdo the sort of large sums of money that places like China are spending on green energy and by implication on their–

McSherry: My concern is that we’ve gotten a late start on a lot of the stuff. You know, countries like Denmark are leaders in wind technology. You know, why isn’t that happening in this country? I’m hopeful that some of the stimulus money is directed that way. You know, one of the dangers of stimulating the economy with large sums like that is there’s a lot of make-work that’s put out there just to keep people employed, rather than investing in infrastructure projects that will benefit us going forward. I think we’ve got to upgrade the electrical grid. We’re talking about everybody plugging their automobiles in. We can’t get through a summer with running our air conditioners without having brownouts and problems. There are real serious problems in that area, so I think I’d like to see more of the money going towards those kinds of projects.

Hyzy: Yeah, it’s a great point. To emphasize that further, prior downturns were consumer-cyclically led. This upturn is late-cycle manufacturing-led, infrastructure, hopefully, rebuilding-led. And all of that requires the needs for the world’s natural resources. So when we look back on all of this, we may see, again, the start of one of another bubble, which is the buildup of natural resources. But it’s not one year or two years. It’s 10 years. It’s 12 years. Because everybody needs it right now.

Maidment: Yeah, and if that bubble’s going to build up anywhere, it’s going to build up in China, so I’m wondering what your perspective is on the Chinese economy? In particular, can it shift itself from being export dominated, as it has been, to being more domestic demand-led, and the Chinese somehow taking up that global leadership through the Chinese consumer that America used to have?

Hyzy: Without question. They have to. The single greatest thing that the world does not want to see, whether you’re China, the United States or any other Central Bank or major superpower is inflation, higher interest rates, and a significant uptake in commodity prices that is not controllable. Each Central Bank around the world will try to manage themselves that way.

At the same time, there is a massive consumer movement going on in China right now. Everyone wants it to happen in one year or two years. They think very long-term. They have a 25-year plan. They have five-year plans every five years, so there’s a reason why this is a G-2 led recovery. China and the United States. U.S. repairing, China taking the gavel. At the end of the day, look at the last ten years. We had surplus savings in Asia, led by China. And we had the buildup of secular leverage in the rich world, i.e. the United States.

There’s a reason why that happened. That’s being unwound, and that’s actually a really good thing. So that’s going to lead to, in our opinion, better rebalanced growth, a healthier environment when we get through all of this. And certainly, without a question, it’ll become the second-largest economy, and it will be more domestically-led than export-led in the next ten years.

Maidment: Bernie, for investors, though, China more to be worried about than to feel good about at this point?

McSherry: I think there’s some risk of bubbles forming in some of the real estate areas. You know, we hear a lot of things about Shanghai, that things are getting a little overheated there, but I certainly think there’s great opportunity there. And I got to get back to what we were saying earlier. You know, they’ve got a lot of dollars. They’ve got to spend them eventually.

Maidment: Carol, your view on China for the year?

Pepper: Yeah. I think China will continue to be a very attractive market. I think an interesting way for individual investors to play China is through ETFs. Because ETFs are very liquid. If things start, you know, if we have a shock and suddenly things start to lose value, get out. Because China is going to, over the next 10 years, do extremely well. But there could be other down years, where it’s down 70%. You don’t have to go through that. You can sell your ETF. Wait for it to go down 70%, and re-buy. Trying to maybe more of a trading play, you’re going to have to be on top of it, and trade it actively, rather than buy and hold it. I think you’re better off that way. You’re going to sleep better at night, and there’s no real need to be in it when it goes through its inevitable overbuilds, and then pullbacks, and overbuilds, and pullback. But it is the area of the world where growth will be most prominent in the next 20, 25 years.

China vs. BRICs

Maidment: Chris, do you see China as being more attractive for the U.S. investor than, say, the other BRICs of Russia, India or Brazil?

Hyzy: You know, I think there’s a difference between investing in China vs. investing on what China does or what China will be. So we focus on the inputs to China’s output, and that really is Latin America. That’s natural resources. That’s almost every country in Latin America has something as it relates to a resource that China needs.

The big switch for most private investors is going to be to figure out how to invest in those companies that are going to benefit from the China consumer movement. And a lot of those companies will be in the United States. They’re tech-based. Energy companies. The oil, sands companies up in Canada, Australia. The currencies of the commodity markets, etc.. And that may be the big switch that goes on, rather than saying, “I’m going to own Chinese A-shares and B-shares.”

Maidment: Let’s go around the table again. Outlook for the U.S. economy in 2010? Risk of a double-dip recession? Bernie?

McSherry: It’s always a risk. I think we’ll avoid it, but there will be a few times during the first quarter or so that we’re worried about it.

Maidment: Carol?

Pepper: Less than 10%.

Maidment: Chris?

Hyzy: Very low. A lot of talk about it. Not going to happen.

Maidment: And if you had $2 left to invest somewhere in the world, where would you put them? Bernie?

McSherry: I would put them both in the same place.

Maidment: No, you can split them. You can split them.

McSherry: I’ll put $1.50 on America, and I’ll put about a half a dollar in emerging markets.

Maidment: Carol?

Pepper: $2 in China.

Maidment: Chris?

Hyzy : $1 in the emerging markets, $1 in U.S. large-caps.

Investing in China

Maidment: I think China actually faces a lot of problems. I think it’s going to sort of blow up politically in 2012. I think the leadership succession is going to be very, very messy. And the current leadership does not have control of that. And there’s a lot of underlying social unrest as well. I mean, is that something that would concern you, Chris, in your investment strategy now?

Hyzy: No question about it. The reason why it would concern me the most has a lot to do with the 300 million citizens that are outside the primary cities and secondary cities that still need to come in to better their lives. So in the short term, it’s a huge concern. Anytime when you talk about the size of China or a country the size of China, and the control they have with their ethics, reserves, etc., and the number of citizens that are still trying to find jobs, etc.. When you talk about politics and the change in leadership, that’s a big concern. I would use that as an opportunity, quite frankly, to invest in the long-term for what China needs, not necessarily in their stock markets, per se. And that’s what Carol was talking about before is be careful.

These are 60% to 70% swings in these markets that are very common for them. In some cases quarter over quarter, so be very careful. Do it selectively. For most private investors, it’s the ETF equation. For those very, very sophisticated, ultra-high net worth investors, there’s still a lot of money hunting for distressed opportunities in areas that China needs.

Maidment: Yeah, you make a very strong point about the scale of China. I mean, you know, America talks about having 17 million people unemployed. China lost that many jobs in export industries in Guangdong alone.

Hyzy: Yeah. That’s a great point. Most people don’t realize that China lost more jobs last year or in ’09 than the United States did.

McSherry: Yeah, but you’ve got to worry about stability. I agree with you, particularly on the fringe areas of the country, in terms of geography. I was in Tibet two years ago, and there’s grinding poverty for the Tibetan people, but millions of Han Chinese have moved in, and have great jobs. And there’s a lot of unrest, and the hatred is just below the surface there. Obviously with the Uyghurs, we’re seeing in other parts of the country, they are not as stable as we like to think they are.

Maidment: No, I mean, historically, China is always broken up North, South and the West. And the West seems very fragile right now and the low you’re seeing, I think, a gradual shift of economic power westward in China as well. And the emergence of cities like Chongqing now is really on the same scale as a Harbin or a Beijing or a Shanghai is how it’s

Pepper: And as you raise the standard of living for people, and expose a greater percentage of the population to, what we would call, Western standards of living, those folks are going to want the same thing as everybody else has.

And again, basic things like health care, an aging population, worrying about you know, there’s a concern about what’s going to happen with all these elderly people, and how are they going to fund taking care of them. Outbreaks of viruses that can travel through just an enormous population. There’s a lot of social issues there that, frankly, in some ways, are easier to cope with a more centralized government. I mean, I think that’s one of the reasons why you don’t see, China may want to move toward a democratic, more of a democratic or capitalistic-type society to make money, but from a social perspective, the chaos that could potentially ensue is terrifying to them.

I mean, I don’t see how they can do it necessarily. So I think you’re going to continue to see a very centralized form of government over there in the near term, but a lot of innovative thinking going on. Because they do have the money to put into it to solve these big social problems. I mean, that’s the good thing. You know, a lot of interesting work is going to come out of China for the rest of the world.

Green Technology

Maidment: So, I mean, areas like green technology, where a lot of money is being put. But, I mean–

McSherry: We see it ourselves. There are areas that our system is struggling with to muster up the political will to tackle. One of the strengths, it’s not always a great thing. One of the strengths of that system is that they can mobilize large resources towards long-term problems, and work on them. I’m not saying it’s worth the political repression, perhaps. But we can probably learn a few things from their long-term outlook.

Maidment: Yeah. And also, I mean, if you think of the way they solved the credit freeze problem, that they just ordered the state banks to lend.

Pepper: Right.

Hyzy: That’s a great point.

Pepper: I bet you Obama wished he could do that.

Hyzy: That’s a form of “cocialism.” It’s half capitalism, half socialism. You’re trying to strike the right balance. When you have big issues like you’ve mentioned before, but yet you have this goal in mind, that we have to create this large, domestic economy, which will create that consumer enthusiasm that you need to stay away from the social strife that we’re all concerned about. And the Internet is only going to advance how quickly people see what Western, so-called Western standards are. And that’s going to accelerate the whole shift.

Maidment: So we just have a minute left. Around the table once more. Short-term, long-term on China? Bernie, bull or bear?

McSherry: Well, you’ve got to be bullish long-term. And I think you probably have to be bullish in the short term as well.